Accounts closedown time is approaching once again. Whilst IFRS 16 is likely to be most prevalent on many people’s radar there is still of course all the same stuff you have to do every year. If the authority has made significant new types of investments, or for that matter made significant changes to their loans, this may mean some new financial instrument accounting to get your head around.
Arlingclose has particular experience in assisting clients with the area of the accounts that relates to financial instruments. We also assist with capital accounting and particularly any transactions which relate to the CFR (Capital Financing Requirement) and MRP (Minimum Revenue Provision or Loans Funds Repayments in Scotland). This is typically seen as a complicated area that can be a challenge for even the most talented accountants. In this article we discuss a few of the areas that we find that many people find the most difficult.
Soft Loans
This is usually where you have made a loan to a third party, such as your subsidiary or a local charity, at no interest or at a below market rate of interest. Sometimes it can also apply to loans received – you may have got an interest free loan from central government for example.
Unlike most normal loans you can’t just account for interest at what is being paid – which may be nothing. You are required to charge income and expenditure with interest at the ‘effective interest rate’ this is what the interest would be if the borrower had gone to a bank rather than your good selves for a loan. As this is going to be different to what you’re receiving this difference needs to go somewhere: it goes to changing the amortised cost that the loan is held at on the balance sheet. This amortised cost then changes every year. As with many things, local authority statute is different to accounting practice regarding soft loans which requires further adjustments. For council tax payers you have to essentially reverse out all the accounting you just did in the Income & Expenditure Statement.
The good thing about soft loans is that you can set out the schedule of double entries when the loan is first made and then you basically just need to stick to it for the rest of the loan’s life. The fair value of the loan, which has to be disclosed, does need to be recalculated every year however.
Accounting for Bonds and T-bills
A little like soft loans, for bonds the cash interest you actually receive (or if you are a bond issuer pay) is often different to the interest that you account for. This is because bonds are often sold at a premium or discount above par. Par is principal value of the bond that will be paid on maturity, normally £100 per bond. If you have purchased the bond ‘below par’ you will have paid less than £100 for it. If the bond is paying 2% interest this will be interest on the par value – so £2 on a £100 bond. However, this isn’t really representative of the interest you’re really getting if you only paid £95 for a £100 bond. Therefore, to represent a true and fair view of the accounts a calculation is needed as to what the ‘effective interest rate’ is and that is accounting for in the Income & Expenditure Statement. As with soft loans the difference goes to changing the amortised cost of the bond over time. Variable rate bonds will be required to be re-looked at regularly to account for their changing interest rate. I should also mention that the treatment is different if bonds are purchased with the intention to sell them in the near future as opposed to hold them to maturity.
T-bills are tradable instruments that the UK government issues to borrow short term. These do not pay regular interest, but will always be issued below ‘face value’ (T-bill equivalent of par value). So for example, you will pay £999 for a £1,000 T-bill. This involves a calculation of effective interest and amortised cost in a similar way to bonds.
Debt Restructuring
This is where loans have been repaid early, sometimes being replaced by new loans. Usually when you repay a loan there is a premium (money you have to pay to the lender) or a discount (money that the lender repays you). The rules around this do differ slightly in different regions of the UK, but typically local government statute allows or requires you to spread the effect of this premium over a number of future years. This requires adjustments to go through the Financial Instruments Adjustment account which may need to be maintained with reference to a specific repayment for a number of years.
It can get even more complicated when a loan is repaid and then replaced by another one on terms which are deemed very similar. In these instances, the accounting has to be different as you must treat the loan as being ‘modified’ rather than one loan being repaid and another one being taken out.
Stepped Loans
These are typically where you have a loan that initially charges you a lower rate of interest that then increases after a certain number of years. These were common structures when LOBOs were initially arranged. Giving a true and fair view of these loans means that the proper interest rate needs to be accounted for as essentially an average of the overall interest being charged on the loan – you aren’t allowed to just take the saving in the short term. So, this is another example of where your effective interest rate charged to the Income & Expenditure Statement will be different to the cash interest, with the difference going to the amortised cost of the loan. As with soft loans once set up the same schedule should be able to be applied to the life of the loan.
For loans arranged before a certain date there is statute which allows you to reverse out all the accounting practice you’ve just done into a non-usable reserve. Adding an extra layer of accounting to some but not all of these loans.
Anything that goes through the Capital Adjustment Account
Private sector firms won’t have a capital adjustment account it is an unusable reserve in place purely for local authority specific accounting that is issued by statute as opposed to accounting practice. As the name suggests the account relates to things that are capital expenditure. Some of this account is used for reversing in or out costs that are not deemed a true charge to council tax payers, such as depreciation or impairments on capital assets. Some of it is to do with other capital financing rules in local authorities: for example, financing a capital purchase with capital receipts.
Its nature of being local authority specific, quite complicated and not proper accounting practice can make the Capital Adjustment Account – or CAA – quite error prone. The nature of capital transactions being for quite a lot of money can mean a misposting can be a substantial amount in the wrong place. If not spotted an error can get carried forward for many years before anyone notices, by which point nobody can remember what happened in the first place. Things being wrong in this area can have real world quite sizeable implications particularly relating to MRP (loans fund repayments in Scotland) which is impacted by transactions that go through the CAA. What you especially want to avoid is your auditors wanting you to correct a previous error that creates a large one off and unexpected revenue cost.
Non-SPPI loans
These are most commonly seen in loans made by an authority, sometimes to a subsidiary company. ‘SPPI’ stands for ‘Soley Payment of Principal and Interest’. Non-SPPI loans could be summarised broadly as loans which are ‘unusual’ because the payment to you as the investor is not made up of just ‘normal’ principal and interest repayments. The distinction between what is and is not SPPI is often quite nuanced. The most common examples that Arlingclose sees are loans to residents to purchase property where the amount repaid is linked to the property value of their house. Loans where the borrower can contractually just not pay you if they don’t have the money would also fall into this category. These types of loans have to be held in the balance sheet at their fair value, so the accounting is different. Working out their fair value – linked to property prices or the financial health of the borrower – can also be more complex. Sometimes these types of loans are in reality not loans but shares, a ‘loan’ where they don’t pay any interest and never have to pay you back is not a loan!
Getting the accounting right for these can affect the balance sheet and have revenue and capital financing implications. For example, shares will always be considered capital expenditure whereas a loan may not. Non-SPPI loans will also not require an Expected Credit Loss (ECL) charge in the way that normal loans do.
Hopefully this insight has highlighted areas of the closedown process that may need extra care and attention, particularly if new transactions have been entered into during the current financial year. If you require any assistance with these or similar areas, please contact Laura Fallon at lfallon@arlingclose.com or on 07702 788303.
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